The Road from Supervision to Resolution

A proper understanding of the post-crisis supervisory process is an essential angle for assessing banks’ credit risk, argues Sam Theodore, group managing director, financial institutions, at Scope Ratings — even if the likelihood of resolution should not be overstated.

European banks’ enhanced regulatory ecosystem remains centre stage for investors and other market participants. Scope Ratings identifies two main components in the new regulatory architecture: the metrics, and the process. In most cases, analysts focus primarily on the impact of prudential metrics (capital, leverage, liquidity, or, more recently, bail-in capacity) when assessing banks, neglecting the equally essential role of the supervisory process itself.

Based on historical evidence, for banks — unlike other credit sectors — it is mostly regulatory action that leads to default-like scenarios. Bank credit ratings must therefore assess the probability of regulatory action. Ours do exactly that (we detail that in our research and methodologies). For investors and other market participants, it should be evident that a proper understanding of how supervisors operate and what they aim to achieve is an essential component of evaluating banks.

Post-crisis bank supervision has moved from being largely procedural (“box-ticking”) to being more substantive and intrusive — although the latter is still a work in progress. As banks have had to become more receptive to the feedback and demands of supervisors, the latter’s role is also becoming more catalytic (agents of change). This should be reassuring for investors — to the extent that they trust the system — as supervisors’ main brief is to keep banks safely away from regulatory borderline situations.

Unlike the pre-crisis years, the bank supervisory process now starts upstream, with the assessment of business models, governance, and risk culture and management, before focusing on the downstream assessment of capital and liquidity risk. Another significant difference from the past is the increasing use of stress tests as a supervisory tool.

SREP explained: moving to a more dynamic and comprehensive assessment of individual bank risk

Under EU regulations, the Supervisory Review & Examination Process (SREP) includes guidelines on procedures and methodologies for bank supervisors. As of the start of this year it is a mandatory process, although in practice it has already been followed last year by EU supervisors, including the European Central Bank (ECB). SREP entails a dynamic and comprehensive assessment of a bank’s risks and viability over a supervision cycle (from 12 to 36 months, based on proportionality). The supervisory work relies on resolution and recovery plans, on regulatory reporting (COREP and FINREP), on banks’ internal reporting and strategic plans, as well as on third-party reports (e.g. from equity analysts and rating agencies) — in addition to ongoing dialogue with bank management teams.

Each of the four areas is scored from 1 (“no discernible risk”) to 4 (“high risk”), or alternatively F (“failing or about to fail”). Based on the results of this assessment, supervisors may ask banks to take various actions, such as allocating more capital or liquidity, adjusting business models or governance, and implementing management changes.

SREP is used by supervisors to determine individual banks’ Pillar 2 capital requirements, the additional capital needed to cover risks not captured or only partially covered by Pillar 1 requirements. SREP capital requirements that include both Pillar 1 and Pillar 2 are becoming a more definitive regulatory indicator. And as we have seen, SREP capital requirements are increasingly being disclosed by banks (with the prior agreement of their regulators) in the UK, Nordic region, and also increasingly in the euro area. Going forward, we expect SREP capital, to the extent that it is more consistently disclosed, to become in fact the overriding solvency metric for the market to focus on.

Early intervention as a distinct step prior to resolution

Triggers for early supervisory intervention may be: (i) an overall SREP score of 4 (or 3 overall with a 4 on one of the main areas of supervision); (ii) material anomalies identified by SREP even in the absence of a formal re-scoring; or (iii) the occurrence of “significant events” (including a material rating downgrade that might trigger market-access problems).

Early intervention can include more severe steps, such as the removal of management, temporary administration, cancelling coupon payments on capital instruments, or the conversion or write-down of principal on capital instruments — thus reaching the point of non-viability (PONV).

Should early supervisory intervention be insufficient to prevent a bank from sliding into a “failing or about to fail” situation, placing it into resolution would then be considered. Below we highlight the normal supervisory process before the resolution scenario is reached.

Resolution is a very extreme scenario for a bank with decent-to-good fundamentals, therefore senior debt should be relatively safe

Often, in the heated market debate about the ranking of senior unsecured debt in resolution (partially fuelled by suboptimal clarity from regulators), the degree of comfort with a particular bank’s credit fundamentals seems to be falling by the wayside. In the end if being placed in resolution remains a very remote probability for a bank with decent-to-good fundamentals, exactly how senior debt would be treated in this extremely unlikely scenario, while definitely worth knowing, should not perhaps be the central concern for investors.

Conversely, if being placed into resolution became a plausible scenario for a bank with deteriorating fundamentals, investor concerns should go well beyond the eligibility of senior debt in MREL/TLAC. Said otherwise, a sufficient number of lifeboats on deck will not convince anyone to board a ship in a creaky condition.

We have to assume that a modern-day bank supervisor worth its salt will do its utmost and then some to prevent a bank from sliding into a situation of structural weakness in which resolution would be necessary. A large bank being placed in resolution would undoubtedly be a costly and painful outcome for the financial stability of a country. Even if taxpayers were not to recapitalise the bank, a ripple effect on market sentiment and a likely wider panic affecting other banks could be envisioned. Depositors may well be exempted from bail-in, but general fear would undoubtedly spread.

A resolution authority’s main brief should plausibly be ex ante resolution avoidance (through planning) rather than ex post resolution management.

To conclude, the intense debate about the process of resolution and bail-in should not translate in investors’ minds into a heightened conviction of a resolution scenario actually occurring. As the details of resolution are clarified and to the extent possible made public — MREL/TLAC levels, composition of eligible liabilities, timing, etc — investors should again focus on assessing the fundamentals of banks. Extensively debating funeral arrangements if the person is healthy can go only so far.

This should be all the more true in the case of the euro area, where supervisors and resolution authorities are two separate bodies (the ECB in Frankfurt and the Systemic Risk Board (SRB) in Brussels, respectively) — unlike, for instance, the UK, where the Bank of England is both resolution authority and prudential supervisor (the latter via the Prudential Regulation Authority (PRA)). Placing a large euro area bank in resolution is likely to be a far messier process than elegantly passing the baton from competent authorities (ECB) to resolution authorities (SRB).